CAN YELLEN´S FED SIDESTEP LURKING MONSTERS ? / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

December 17, 2013 8:58 am

Can Yellen’s Fed sidestep lurking monsters?

By John Plender

There is always a crisis lying in wait for central bankers

When Janet Yellen takes over as chair of the US Federal Reserve from Ben Bernanke in February, she will confront an economy that is ostensibly in good shape. The US has recovered better than any of the other big developed world economies. Deleveraging has reduced private sector debt to sustainable levels and there is a good chance that the next leg of the recovery will be powered by investment. Even public sector debt looks more manageable after this year’s intense fiscal squeeze. And there is still slack in the economy, which is helpful in terms of meeting the Fed’s anti-inflationary mandate.

Yet Ms Yellen will no doubt be conscious that a similarly benign outlook was mooted before Mr Bernanke’s ascent to the Fed chairmanship in 2006. Economists were still talking about the “great moderation”, though the “great credit crunch” was only 18 months away, subsequently to be followed by the greatest financial crisis of all time. It is an unpalatable fact of central banking life that there is always a crisis, as well as a bunch of hostile folk on Capitol Hill, lying in wait. The only question is whether the lurking monster hits you or your successor.

The incoming chair faces this challenge with a much more fragile balance sheet than the one inherited by Mr Bernanke. At the end of 2006 the Federal Reserve Banks’ combined balance sheet amounted to $873bn, with capital of $30.6bn or a very slender looking 3.5 per cent.

The balance sheet has since ballooned to a fraction under $4tn as a result of the Fed’s asset purchasing programmes, of which Ms Yellen has been a conspicuous supporter. Meantime the capital is now down to a threadbare 1.4 per cent. Since the Fed includes Treasury and agency securities at amortised cost rather than fair value, the capital would be much greater at today’s market values. But those values have been puffed up by the Fed’s own buying programmes. It would not take much of a jolt in the bond market to throw it into technical insolvency.

Backdoor recapitalisation

That is arguably academic because the Fed is ultimately a creature of the US government and it can anyway recapitalise itself by the backdoor through profits made on seignorage, or the printing of money. Yet it is not clear, in these days of Congressional fiscal incivility, whether formal recapitalisation could be taken for granted. As for backdoor recapitalisation, it works up to the point where markets fear the inflationary consequences of so doing and lose faith in the central bank.

It is a tribute to Mr Bernanke’s handling of the crisis that few are raising concerns about the balance sheet today. But Ms Yellen has to establish her credibility and the terrain is becoming tougher as the markets’ obsession with tapering and scepticism about forward guidance suggests. Monetary policy is now determinedly experimental and the attempt to link it to real outcomes such as unemployment – which is, after all, a lagging indicator – brings back memories of the inflationary misery of the 1970s.

One very obvious risk is that policy rates will remain low so long that asset prices reach territory from which they cannot return without a big bump that might expose the fragility of a banking system that is even more concentrated than before the crisis. Or markets might conclude that the Fed has given up on inflation so that inflationary expectations become unanchored. At that point the balance sheet might start to matter as credibility became a serious concern.

An elegant exit from unconventional measures will require the kind of footwork that does not come easily to central bankers.

External threats


Of the other lurking monsters, an obvious one is that Ms Yellen could be sandbagged at any time if Washington’s fiscal civil war results in a bond market plunge and a collapsing dollar. Less obvious are the external threats, but they are no less real.

The commitment of China to open its capital account, reinforced at the leadership’s recent third plenum, could prove disruptive for global markets. If there is a substantial outflow of hitherto trapped savings, the Chinese authorities might have to sell US Treasuries held in their official reserves to prevent a collapse of the renminbi. That could seriously threaten financial stability in the US.

The greatest unknown is whether the Fed has adequate weapons to stabilise the financial system in a renewed financial crisis. After the collapse of Lehman Brothers in 2008 Mr Bernanke was able to terrify policy makers on Capitol Hill with the prospect of a systemic meltdown. Since then the political appetite for bailouts has dwindled to near-zero.

If a megabank turned out to be hugely insolvent, with contagious consequences, the Fed chairmanship would not, at the risk of understatement, be a bed of roses.



The writer is an FT columnist

Copyright The Financial Times Limited 2013.